Chasing Bonds

Last week, two co-workers and I had a foot pursuit. The short version is that the bad guy didn't want to stick around after the K-9 hit on his car. One of my partners is a former college football player and still built like one. The other is vertically challenged and, to be gentle, not swift of foot. Me? I just have long legs. About 70 yards into the chase, my shorter friend decided it was best if he returned to secure our cars and some other evidence since he was quickly dropping behind. I played radioman and kept the bad guy in sight, while the football player did his thing, catching the guy after another 50 yards or so.

Afterwards, the analogy struck me: many of us use our money to chase trends, hoping we will catch up, but without knowing whether we have long legs, lead feet or Division I football potential.

Financial advisors have historically recommended investing mostly in stock-based mutual funds. The stock market has a history of yielding the most consistent overall returns, averaging about 8% per year. However, with the stock market crash of 2008/2009, many people are scared of investing in stocks. This jittery feeling is compounded by the fact that bond-based mutual funds have performed quite well since the crash.

This month, we’ll look at bond-based mutual funds to examine why they are successful and if you should invest in them.

What are bonds?

Bonds in general are debt issued with a promise to repay the debt at a fixed point in the future. Technically, these are broken into three categories: bills, notes and bonds. A bill is a debt that has a maturity of one year or less, meaning that the issuing entity (such as the federal government) promises to pay the holder in 12 months, or less if it is, say, a 30- or 90-day bill. A note has a maturity of two to ten years, while a bond has a maturity of more than 10 years. For the rest of the article, I will refer to them all generically as bonds, since a bond-based mutual fund normally invests in all three types of debt.

The bond will normally be assigned a fixed interest rate. That interest may be paid at regular intervals, say monthly for longer bonds or annually for shorter ones, such as notes. For example, if a company (or government) issues a $100 bond at 4% interest, it might promise to pay $4 per year to the owner. At the end of the term, the issuer will pay the owner the original $100 as well. Since bills are very short term loans, they normally do not pay interest. The owner makes money by buying the bill for less than the $100 promised in, say, 90 days. He might buy it for $99, earning 1% for ¼ of a year, or 4% for a year.

That is simplified math, especially since compounding complicates things and no one issues $100 bonds (I use $100 because the math is easier to understand). It gets even more complicated because interest rates fluctuate based on how people feel about the future of the economy. Generally, when people fear inflation, they demand a higher interest rate. That is because they expect that the $100 they are getting in two, ten or 20 years will not be worth the same as the $100 they paid today.

To compensate for interest rate fluctuations, bonds are bought and sold at a premium or discount to make the net interest rate meet the market. For example, if the federal government issues a 3% note for 2 years, a buyer would expect to pay $100 now, get $3 per year for two years and $100 back at the end of the two years. But what if the market wants a 5% interest rate? The price of the bond then drops to roughly $96. That means the buyer gets $3 the first year and $7 the second year (paid $96, received $100, plus the $3 interest). That's $10 for two years, or 5% interest. The system works in reverse too; if the interest rate offered is higher than the market expects, the price of the bond is actually higher than the asking price of $100 to make the overall rate meet the market.

So What?

Why does this matter? Because it explains why bond funds have done so well over the past 18 months. Interest rates are near historic lows. That means that a $100 bond issued by a company with a 6% interest rate is worth more than $100. The mutual fund gets to show that higher value on its books and may even sell the bond to make an immediate profit. This effect is compounded by the fact that bonds are less volatile than stocks, and investment money has to go somewhere. As more money goes into bonds, the prices go up (driving interest rates down), and making the bond funds look even more profitable.

Should you buy bond-based mutual funds? Sure. But not just today: always. A portion of your investments should be in bonds just to protect a portion of your investments from the type of stock market chaos we have seen over the past two years. The ratio you invest in bonds should be based on two items: your time to retirement and your tolerance for risk.

The farther away your retirement is, the more time you have to wait for the stock market to recover. Since stocks normally outperform bonds, you benefit from the better return and have your nest egg grow faster. As you get closer to retirement, you should shift more of your investment from stocks to balanced funds: bond funds and money market accounts. These investments don't see the highest returns, but they also are not as liable to collapse.

The exact percentages for different investments at different ages vary according to whom you ask. But it always has to be balanced against your tolerance for risk. Some people don't mind losing $20,000 in a year if they are confident they can make $30,000 a few years down the road. Some people get heartburn over a $5,000 drop. Bonds reduce overall risk, but limit future growth. Either way, your investments should not cause you grief; they should be a source of comfort and hope. If you are more like the first person, then you can put most of your money in stocks. If you are more like the second, then you need to keep more in bonds and other conservative investments.

Conclusion

The market collapse and the great performance of bond funds has made people re-examine bonds as an investment. The stellar recent performance of bonds is partially due to low interest rates, combined with the lingering fear of the stock market. While bonds should always be part of an investment portfolio, most people should not move exclusively to bonds. Remember, when inflation returns, the Federal Reserve will raise interest rates. All those 4% bonds will lose value as the interest rates go to 7% or 8%. When the economy regains its footing, stocks will start performing again, causing stock prices to rise.

As always, remember that any loss you see now is merely a paper loss. When you sell and transfer the money to a different investment, you lock in the loss and make it real.

That doesn't mean you should not ditch bad investments; it just means you shouldn't chase the trends with your investments because if you get a late start and your legs aren't long enough, you'll get left behind.